Growth and the Effects of Inflation

NBER Working Paper No. 4523Issued in November 1993NBER Program(s): EFG

In this paper, we analyze the effects of changes in monetary growth rates in the context of models of endogenous growth when the demand for money comes from a cash-in-advance constraint. We explore two alternative avenues through which the rate of inflation could affect the overall long-run rate of growth of the economy. The first of these is through nominal rigidities in the tax code. The particular rigidity that we examine is for depreciation allowances that are fixed in nominal terms. The second avenue that we examine is a distortion of the labor-leisure choice when a Lucas-style model of effective labor is used. In both cases, the welfare costs and growth effects of various monetary growth rules relative to a constant money supply are studied. It is found that both the welfare costs of inflation and its growth effects are quite small at low to moderate levels of inflation. However, at rates of inflation that are high by U.S. standards but not uncommon in developing countries, the magnitude of both the growth effects and the welfare costs of inflation depend on the specification of the model. If cash and credit goods are substitutes there are no growth effects and moderate welfare effects. If the two goods are complements there are sizable growth effects and large welfare effects.